Question

For problems each problem 1) determine whether aggregate demand or short-run aggregate supply is being impacted. 1a) If aggregate demand is being affected, explain which component(s) (C, I, and G) are changing. 2) Graphically show the shift. Your graph should contain the AD, SRAS, and LRAS curves. 3) compare the original price level in the economy to the new price level as well as the new level of production to the original level of production. Which curve shifts to move to market back to a long-run equilibrium? In which direction? Show this graphically. Compare the very initial price level to the final price level. Compare the very initial level of real GDP to the final level of real GDP. Assume that LRAS is not impacted.

1. The Federal Reserve increases the interest rate.
2. Artificial intelligence is widely used drastically increasing worker productivity.
3. The average American is fearful of the future.
4. The state of Pennsylvania sends a $600 tax rebate check to each tax payer.
5. The federal government increases its spending on defense.

Answer 1

In each graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with long-run equilibrium price level P0 and real GDP (= Potential GDP) Y0.

(1) Fed's increase of interest rate will lower investment, decreasing aggregate demand. AD curve will shift to left, lowering price level and lowering real GDP, causing a recessionary gap in short run. In the long run, lower price level lowers input costs, so firms raise production, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring original real GDP and eliminating recessionary gap.

In following graph, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, with recessionary gap being equal to (Y0 - Y1) in short run. In long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.

(2) Increase in labor productivity will increase production, increasing aggregate supply. SRAS curve will shift to right, lowering price level and increasing real GDP in short run. In the long run, prices and wages adjust, so aggregate demand will fall. AD curve shifts leftward, intersecting new SRAS curve at further lower price level but restoring original real GDP.

In following graph, SRAS curve will shift right from SRAS0 to SRAS1, intersecting AD0 at point B with lower price level P1 and higher real GDP Y1 in short run. In long run, AD0 shifts left to AD1, intersecting SRAS1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.

(3) When Americans are fear ful of the future, consumer confidence falls, which lowers consumption demand, decreasing aggregate demand. AD curve will shift to left, lowering price level and lowering real GDP, causing a recessionary gap in short run. In the long run, lower price level lowers input costs, so firms raise production, increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring original real GDP and eliminating recessionary gap.

In following graph, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, with recessionary gap being equal to (Y0 - Y1) in short run. In long run, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.

(4) The tax rebate increases disposable income, which increases consumption demand, increasing aggregate demand. AD curve will shift to right, increasing price level and increasing real GDP, causing an expansionary gap in short run. In the long run, higher price level raises input costs, so firms lower production, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real GDP and eliminating expansionary gap.

In following graph, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with expansionary gap being equal to (Y1 - Y0) in short run. In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0, eliminating expansionary gap.

(5) Increase in defense spending increases government expenditure, thus increasing aggregate demand. AD curve will shift to right, increasing price level and increasing real GDP, causing an expansionary gap in short run. In the long run, higher price level raises input costs, so firms lower production, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real GDP and eliminating expansionary gap.

In following graph, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with expansionary gap being equal to (Y1 - Y0) in short run. In long run, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0, eliminating expansionary gap.